Japan knows what to do to get itself back on track, it needs no advice from anybody, it has all the human resource required to identify and tackle its current problems. The Japanese know how to fix Japan and I have no doubt in their ability to get things right.

Those who know Japan, have an eternally abiding faith in the ability of the country to get out of mess, they say that the country always seems to shuffle its feet but then snaps into action when faced with a crisis. It did so in 19th century, adopting modern ways to avoid being colonized, and again after the Second World War. Japan was the world’s second largest economy for 40 years. But the qualities that made it an economic power house in the 20th century: easy capital, big companies, excellent education, disciplined and efficient management, and stable lifetime jobs for male breadwinners- are out of fashion with the 21st century. Japan’s biggest obstacle today is itself.

In the recently released global ranking of Newsweek magazine’s 100 Best Countries in the World, Japan was placed a not quite impressive 9th position of the overall ranking. Except in the health category which Japan undisputedly holds the 1st position, it hovered around 4th to 10th position for other categories such as education, economic dynamism, quality of life and happiness.

Its reluctance to change has become has led to an anticlimax for this once economic power house. Just some few weeks ago, when the global media was abuzz with the news of China overtaking Japan as the world’s 2nd largest economy, the general mood in Japan was resignation and hopelessness, it is understandable why such mood can overtake a people once proudly revered for their once enviable achievements.

Despondency and resignation is only naturally expected after being faced with two lost economic decades characterized by a protracted deflationary cycle, declining growth and an ageing population.

But we must also remember that “faith without work is dead”. Without dramatic reform, Japan will slip swiftly to number four, five and beyond.

However, we still need to take a look at Japan to see if we can identify any new or hidden issues militating against efforts to revive this ailing giant. For this, we need to take a deep retrospective look at Japan through its remarkable history. Starting from the Tokugawa shogunate, the first and second Meiji restoration, the modern era, until the great wars that humbled an ambitious Japan and subsequently its re-emergence as a global economic and industrial power house, and finally, to the current economic challenges that has plagued it.

Historical timeline of Japan:

Since 1854, when the Tokugawa shogunate first opened the country to Western commerce and influence (Bakumatsu), Japan has gone through two periods of economic development. When the Tokugawa shogunate was overthrown and the Meiji government was founded, Japanese Westernization began completely. The first cycle was during Pre-war Japan, the second cycle was during the period of Post-war Japan.

In the Meiji period, Japan, under visionary leadership, inaugurated a new Western-based education system for all young people, it sent thousands of students to the United States and Europe, and hired more than 3,000 Westerners to teach modern science, mathematics, technology, and foreign languages in Japan (O-yatoi gaikokujin). The government also built railroads, improved roads, and inaugurated a land reform program to prepare the country for further development.

In tandem with its objective to promote rapid industrialization, the government decided that, while it should help private business to allocate resources and to plan, the private sector was best equipped to stimulate economic growth. The greatest role of government was to help provide the economic conditions in which business could flourish. Essentially, government was to be the guide and business the producer.

In the early Meiji period, the government built factories and shipyards that were sold to entrepreneurs at a fraction of their value. Many of these businesses grew rapidly into the larger conglomerates. Government emerged as chief promoter of private enterprise, enacting a series of pro-business policies.

The development of banking and reliance on bank funding has been at the centre of Japanese economic development at least since the Meiji era.

In the mid 1930s, the Japanese nominal wage rates were 10 times less than the one of the U.S (based on mid-1930s exchange rates), while the price level is estimated to have been about 44% the one of the U.S.

Comparison of GDP per capita between East-Asian Nations and the U.S. in 1935:

Country

GDP/capita, 1935$ (Liu-Ta-Chung [2])

GDP-PPP/capita, 1990$ (Fukao [1])

GDP-PPP/capita, 1990$ (Maddison [3])

U.S.

540

5,590

5,590

Japan (excl. Taiwan and Korea)

64

1,745

2,154

Taiwan

42

1,266

1,212

Korea

24

662

1,224

China

18

543

562

Oil crisis

Japan faced a severe economic challenge in the mid-1970s. The world oil crisis in 1973 shocked an economy that had become virtually dependent on foreign petroleum. Japan experienced its first post-war decline in industrial production, together with severe price inflation. The recovery that followed the first oil crisis revived the optimism of most business leaders, but the maintenance of industrial growth in the face of high energy costs required shifts in the industrial structure.

The subsequent result of the oil crisis was to increase the energy efficiency of manufacturing and to expand so-called knowledge-intensive industries. The service industries expanded in an increasingly post-industrial economy.

Structural economic changes, however, were unable to check the slowing of economic growth as the economy matured in the late 1970s and 1980s, attaining annual growth rates at only 4 to 6%. But these rates were remarkable in a world of expensive petroleum and in a nation of few domestic resources. Japan’s average growth rate of 5% in the late 1980s, for example, was far higher than the 3.8% growth rate of the United States.

Despite more petroleum price increases in 1979, the strength of the Japanese economy was apparent. It expanded without the double-digit inflation that afflicted other industrial nations (and that had bothered Japan itself after the first oil crisis in 1973). Japan experienced slower growth in the mid-1980s, but its demand-sustained economic boom of the late 1980s revived many troubled industries.

Factors of growth

Complex economic and institutional factors affected Japan’s post-war growth. First, the nation’s pre-war experience provided several important legacies. The Tokugawa period (1600–1867) bequeathed a vital commercial sector in burgeoning urban centres, a relatively well-educated elite (although one with limited knowledge of European science), a sophisticated government bureaucracy, productive agriculture, a closely unified nation with highly developed financial and marketing systems, and a national infrastructure of roads. The build up of industry during the Meiji period to the point where Japan could vie for world power was an important prelude to post-war growth and provided a pool of experienced labour following World War II.

Second, and more important, was the level and quality of investment that persisted through the 1980s. Investment in capital equipment, which averaged more than 11% of GNP during the pre-war period, rose to about 20% of GNP during the 1950s and to more than 30% in the late 1960s and 1970s. During the economic boom of the late 1980s, the rate still hovered around 20%. Japanese businesses imported the latest technologies to develop the industrial base. As a latecomer to modernization, Japan was able to avoid some of the trial and error earlier needed by other nations to develop industrial processes. In the 1970s and 1980s, Japan improved its industrial base through technology licensing, patent purchases, and imitation and improvement of foreign inventions. In the 1980s, industry stepped up its research and development, and many firms became famous for their innovations and creativity.

Japan’s labour force contributed significantly to economic growth, not only because of its availability and literacy but also because of its reasonable wage demands. Before and immediately after World War II, the transfer of numerous agricultural workers to modern industry resulted in rising productivity and only moderate wage increases. As population growth slowed and the nation became increasingly industrialized in the mid-1960s, wages rose significantly. However, labour union cooperation generally kept salary increases within the range of gains in productivity.

High productivity growth played a key role in post-war economic growth. The highly skilled and educated labour force, extraordinary savings rates and accompanying levels of investment and the low growth of Japan’s labour force were major factors in the high rate of productivity growth.

The nation has also benefited from economies of scale. Although medium-sized and small enterprises generated much of the nation’s employment, large facilities were the most productive. Many industrial enterprises consolidated to form larger, more efficient units. Before World War II, large holding companies formed wealth groups, or zaibatsu, which dominated most industry. The zaibatsu were dissolved after the war, but keiretsu—large, modern industrial enterprise groupings—emerged. The coordination of activities within these groupings and the integration of smaller subcontractors into the groups enhanced industrial efficiency.

Circumstances beyond Japan’s direct control contributed to its success. International conflicts tended to stimulate the Japanese economy until the devastation at the end of World War II. The Russo-Japanese War (1904-5), World War I (1914–18), the Korean War (1950–53), and the Second Indochina War (1954–75) brought economic booms to Japan. In addition, benign treatment from the United States after World War II facilitated the nation’s reconstruction and growth.

1980s

Throughout the 1970s, Japan had the world’s second largest gross national product (GNP)—just behind the United States— and ranked first among major industrial nations in 1990 in per capita GNP at US,801, up sharply from US,068 in 1980. After a mild economic slump in the mid-1980s, Japan’s economy began a period of expansion in 1986 that continued until it again entered a recessionary period in 1992. Economic growth averaging 5% between 1987 and 1989 revived industries, such as steel and construction, which had been relatively dormant in the mid-1980s, and brought record salaries and employment. In 1992, however, Japan’s real GNP growth slowed to 1.7%. Even industries such as automobiles and electronics that had experienced phenomenal growth in the 1980s entered a recessionary period in 1992. The domestic market for Japanese automobiles shrank at the same time that Japan’s share of the United States’ market declined. Foreign and domestic demand for Japanese electronics also declined, and Japan seemed on the way to losing its leadership in the world semiconductor market to the United States, Korea and Taiwan.

Japanese post-war technological research was carried out for the sake of economic growth rather than military development. The growth in high-technology industries in the 1980s resulted from heightened domestic demand for high-technology products and for higher living, housing, and environmental standards; better health, medical, and welfare opportunities; better leisure-time facilities; and improved ways to accommodate a rapidly aging society. This reliance on domestic consumption also meant that consumption grew by only 2.2% in 1991 and at the same rate again in 1992

During the 1980s, the Japanese economy shifted its emphasis away from primary and secondary activities (primarily agriculture, manufacturing, and mining) to processing, with telecommunications and computers becoming increasingly vital. Information became an important resource and product, central to wealth and power. The rise of an information-based economy was led by major research in highly sophisticated technology, such as advanced computers. The selling and use of information became very beneficial to the economy. Tokyo became a major financial centre, home of some of the world’s major banks, financial firms, insurance companies, and the world’s largest stock exchange, the Tokyo Securities and Stock Exchange. Even here, however, the recession took its toll. In 1992, the Nikkei 225 stock average began the year at 23,000 points, but fell to 14,000 points in mid-August before leveling off at 17,000 by the end of the year.

1989 Economic Bubble: Enter the Lost Decades.

In the decades following World War II, Japan implemented stringent tariffs and policies to encourage the people to save their income. With more money in banks, loans and credit became easier to obtain, and with Japan running large trade surpluses, the yen appreciated against foreign currencies. This allowed local companies to invest in capital resources much more easily than their competitors overseas, which reduced the price of Japanese-made goods and widened the trade surplus further. And, with the yen appreciating, financial assets became very lucrative.

With so much money readily available for investment, speculation was inevitable, particularly in the Tokyo Stock Exchange and the real estate market. The Nikkei stock index hit its all-time high on December 29, 1989 when it reached an intra-day high of 38,957.44 before closing at 38,915.87. The rates for housing, stocks, and bonds rose so much that at one point the government issued 100-year bonds. Additionally, banks granted increasingly risky loans.

At the height of the bubble, real estate values were extremely over-valued. Prices were highest in Tokyo’s Ginza district in 1989, with choice properties fetching over US.5 million per square meter (9,000 per square foot). Prices were only slightly less in other areas of Tokyo. By 2004, prime “A” property in Tokyo’s financial districts had slumped and Tokyo’s residential homes were a fraction of their peak, but still managed to be listed as the most expensive real estate in the world. Trillions were wiped out with the combined collapse of the Tokyo stock and real estate markets.

With Japan’s economy driven by its high rates of reinvestment, this crash hit particularly hard. Investments were increasingly directed out of the country, and Japanese manufacturing firms lost some degree of their technological edge. As Japanese products became less competitive overseas, it is believed that the low consumption rate began to bear on the economy, causing a deflationary spiral.

The easily obtainable credit that had helped create and engorge the real estate bubble continued to be a problem for several years to come, and as late as 1997, banks were still making loans that had a low guarantee of being repaid.

The time after the bubble’s collapse, which occurred gradually rather than catastrophically, is known as the “lost decade or end of the century” (ushinawareta jūnen) in Japan. The Nikkei 225 stock index eventually bottomed out at 7603.76 in April 2003, moved upward to a new peak of 18,138 in June 2007, before resuming a downward trend. The downward movement in the Nikkei is likely due to global as well as national economic problems.

Japan’s problem are two fold: an intractable credit crisis which has inadvertently derailed the Japanese economy and a thinning labour force characterized by a fast aging population with a corresponding low birth rate that makes the prospect of replenishing the graying labour force harder to achieve.

The core problem of Japan is that it suffers from a gross misallocation of resources both financial and human. Japan has long kept the cost of capital low, to boost investment or help struggling companies. Since the financial crisis started, bureaucratic organs such as the Innovation Network Corporation (INC) of Japan and the Enterprise Turnaround Initiative Corporation (ETIC) have been allocated over billion to revive ailing corporations. A good example of the misallocation of credit issue was the choice by ETIC of aiding a wireless operator which operates on archaic technology.

This is what can be described as “unnatural selection”, in Japan by agencies or lenders charged with the responsibility of providing credit to corporations that require funds. There exist perverse incentives for the allocating credit to needless sections of industry. The system almost guarantees that fresh capital goes to the losers of yester years. And because struggling companies rarely die, new ones do not form. Japan’s bankruptcy rate is half America’s; and the rate at which it creates new firms is only a third as high. Japanese venture capitalists are few. Japan’s bureaucratic allocation of credit seldom spurs animal spirits, instead it breeds zombies.

Japanese banks’ practice of continually extending credit to very weak or even insolvent firms. In Japan’s bank-centred economy, where banks often have the responsibility for corporate monitoring and governance, many lending decisions are strongly influenced by perceived duty to support troubled firms, rather than an objective, non-biased credit risk assessment, such as what is obtained in other developed economies. Both government policy and bank regulations in Japan actually encourage banks to keep extending credit to problematic borrowers, which is unofficially known as “evergreening of credit”.

Japanese banks fund firms to enable the firms make interest payments on outstanding loans, and thus avoid, or at least delay, bankruptcy. This practice allows the banks to have healthier “mirage” looking balance sheets, because the banks report fewer problem loans and make smaller loan loss provisions. The evergreening of bank loans for debt servicing purposes was widespread. With banks more likely to increase loans to firms with weaker financial health. With such practice widespread, banks had more incentives to extend additional credit to troubled firms with loans already outstanding as those same banks’ reported risk-based capital ratios neared their required capital ratios. What mattered most was the need to have a good appearance than the reality of best practices and adequate capital.

A second factor was, corporate connections made it even more likely that banks will extend such credit. Third, government-controlled banks were also more likely to increase loans to financially weak firms. Finally, the only firms that were not under pressure to evergreen loans to the weakest firms were non-affiliated, non-bank lenders. The evergreening of loans in Japan clearly insulated many troubled firms from market forces this may have prevented a bank credit crunch as at that time, instead it made economic problems worse by promoting the allocation of an increasing share of bank credit to many firms least likely to use it.

The pertinent question any observer would be forced to ask is: was there any regulator or were there no regulations to check such practices, or was there an apparent lack of foresight as to where such practices would eventually bring the Japanese economy to?

Japan had its own banking regulator as is definitely the practice. Forbearance by bank regulators had allowed the banks to neglect restructuring of non-financial firms.

Enter the Amakudari: “descent from heaven.”

The term’s literal meaning “descent from heaven” refers to the descent of the Shinto gods from heaven to earth. In modern usage, it refers to the upper echelons of civil service, the civil servants are seen as the deities, and the earth is the private sector corporations.

The amakudari phenomenon partly explains the apparent weakness of Japanese regulators and regulations from preventing the initial factors that led to the present economic woes faced by Japan. Amakudari is the institutionalized practice in Japan, where Japanese senior bureaucrats retire to high profile positions in the private and public sectors. The practice is inherently corrupt and it is a drag on efforts to break the ties between private sector and the state which prevents economic and political reform.

Reforming the reformer (scrapping amakudari)

The relationship that exists between these senior bureaucrats and their former junior colleagues who would have replaced them fosters blind loyalty such as what is obtainable in the ranks of mobsters. It is in Japan’s best interest to break the blind loyalty between the regulators and the regulators, efforts at reform should first target institutional and cultural practices that sustain the greater and familiar economic crisis.

Amakudari and any of its variant (e.g. Yokosuberi or “sideslip” that is retiring to jobs at other government organizations) should be completely abolished. Such practices have proven over time to promote risky business practices. Regulations and proactive regulators are essential to healthy economic growth and sustenance. Japan lacks both because of those the descended from heaven. It is only wise to shut the gates of heaven before Japan is finally ruined by these angels. This will provide the vital first step which would ensure that other measures being muted by experts and economists will eventually get to be fully implemented without prejudice or interference that has always sabotaged such expert opinions.

The seniority and gender issues

Japanese society is one deeply built on respect and age based seniority. This has made Japan lose its knack for getting the best out of its human capital. Despite the superb literacy of its people, the cultural requirement of respect for seniority means that promotions go to the older, not the most able. Young executives with good ideas refrain from speaking up. Retiring presidents are also kept as chairmen or advisers, making it hard for the new boss to undo his predecessor’s mistakes. A rising executive at a big trading house says he was counselled by his seniors to keep his views hidden if he wanted to get on. Half of Japan’s talent is squandered. Only 8% of managers are female, compared with 40% in America and even China’s 20%. A manager at one of Tokyo’s biggest conglomerates says that 70% of qualified job applicants are women, but fewer than 10% are hired, since the work conditions may require visits to factories and mines, where they might perspire in an unladylike way.

Japan is also remarkably “racist” it maintains one of the purest race on earth with very few inter racial marriages. Japan is also not favourably disposed to foreigners and migrants. This has deprived it of the cheap labour offered by migrant workers seeking better living conditions. Instead, it has had to outsource manufacturing to other locations that offer cheap labour, whereas it could have exploited such cheap labour within its boarders. Bosses grouse that the young Japanese eschew overseas posts; even a foreign-ministry official confides that Japanese diplomats prefer to stay at home.

In an attempt to kick-start the Japanese economy again, the government of Japan took a cue from industrial-policy books of old. The trade ministry released a comprehensive new “growth strategy” which identified scores of vibrant sectors meriting government assistance, from overseas construction to attracting medical tourists and migrant workers. The report called for hundreds of reform, very extensive reform in some cases. But the bureaucratic egg heads responsible for drafting the report were promptly drafted to other jobs just a month later. Leaving observers in doubt about the sincerity of the government to implement the outcome of the reports.

This is a clear example of how the old static and “changeophile” Japan scuttles the new. Japan knows what is best for it.